Tuesday, March 25, 2014

In September 2013, I valued Tesla on my blog at about $67 and learned a lesson about how passionate its stockholders were in defending it, viewing it less as an investment and more as a calling. I guess the lesson did not stick, because I am back for more punishment with an updated valuation of the company. Preempting some of the criticism that I may get for my post (and the views that it contains), I would like to put some basic facts on the table before I put down my valuation.

No, I don’t hate Tesla and Elon Musk. In fact, I think Tesla is one of the most innovative companies that I have seen emerge in a while and not only is it changing the automobile business, but it is doing so with style. As for Elon Musk, I wish that the CEOs of other companies were as passionate and visionary in promoting their companies' mission and products, as Musk is with Tesla.

No. I still have not driven a Tesla. I do live in New Jersey, a state that is attempting to use twentieth century regulations to stop a twenty-first century company. I also live five minutes away from Short Hills Mall, where Tesla just opened a showroom. So, I have seen the car, sat in it, but unless I want to create a disaster inside a mall, I don't think I can drive it out of the showroom.

No, I have not sold or plan to sell Tesla short. I also do not work for anyone who has sold short on Tesla, have not been paid (and will not be paid) for this post and won't be cheering if the stock retreats. In the interests of fairness, I do know one person who has sold short the company's shares with some success, but have not partaken in his profits.

No, I don’t believe that my valuation of Tesla is the "right" valuation of the company. It is mine, with my assumptions, estimates and views embedded in it, wrong or misguided though they might be.

No, I don't think you are crazy, if you own or recently bought Tesla. I am a firm believer that each of us has to make our own judgments on what to invest in and why, though we all share the same end-objective, which is to make money on our investments. So, if you have good reasons to believe that Tesla is the right investment for you, I hope it works out for you.

Having dispensed with the formalities, let me move to substance.

Valuation: Then and Now

In my September 2013 valuation of Tesla, I came up with a value per share of $67. At the time, the narrative I provided for the company was that giving it the revenues of Audi (about $65 billion) and the margins of Porsche (about 12.5%), in a decade, still yielded a value below the market price (about $170 in September 2013). Rather than rehash the assumptions I made in this post, you can find them in my original post.

Revenue growth: Tesla continues on its path to higher revenues, reporting revenues of $615 million in the fourth quarter of 2013, doubling its revenues from the same quarter a year ago. The annual revenues in 2013 amounted to just over $2 billion, an almost five-fold increase over the $413 million in revenues in 2012.

Operating margin: In further good news, the operating losses (based upon GAAP) at the firm decreased over the period, down to -$13.4 million in the last quarter of 2013. In fact, adjusting for R&D expenses (capitalizing and amortizing), I estimate an operating profit of $15.46 million in the last quarter of 2013, vindicating the company’s claim that it turned the corner on profitability for the year (albeit with a very different rationalization).

Quality of Growth/Reinvestment: The measure that I used to estimate reinvestment and the quality of growth was the ratio of sales to invested capital. On this measure, as well, Tesla reported improvement in the last quarter of 2013 as the ratio improved from 0.66 in the third quarter to 0.87 in the fourth quarter; a dollar of invested capital generated $0.87 in revenue in the last quarter. (Higher values not this statistic indicate bigger payoffs to investment.)

Risk: There are mixed signals in whether Tesla is getting less risky over time. The volatility in the stock price has actually increased over the last few months, as the stock first dropped on the news about car fires and then recovered quickly and decisively. However, the announcement that the company would raise $2 billion in convertible bonds is an indication that it is opening access in other markets and that will stand it in good stead, if it needs more capital to either grow or survive.

The table below lists the key assumptions in my September 2013 valuation, the changes in the March 2014 valuation and my explanation for the changes.

Battery margins are
likely to be lower (competitive business), pushing down the target margin.

Expected Operating
Income in year 10

$8,178 m

$9,505 m

Comes through from
higher revenues.

Sales/Invested Capital
ratio (to compute reinvestment)

1.41

1.55

Reflects improvement in
last quarter of 2014.

Cost of capital

10.03%

8.86%

Decline in market ERP
from 5.8% in 9/13 to 5% in 3/14. Increase in auto sales led to make it slightly more automobile (60% to 70%) and slightly less technology (40% to 30%).

Probability of failure
(Proceeds from failure)

10% (50% of estimated
value)

0%

Increased access to capital (bond market), lower
losses and larger market capitalization should allow company to survive even major shocks.

Value of equity

$8,152 m

$16,681 m

Increase of 105% in nine
months.

Value per share

$67.12

$99.85/ $118.47

The value per share is
lower ($100), if options get exercised at current price or close to it, and
higher ($118), if option-holders wait and value converges on price.

Note that while the increase in year 10 revenues of $13.8 billion, largely the effect of increased revenue potential from the electric battery market, is substantial, it falls short of what you would expect to see if this were a ‘disruption” of the electric utility market. The improvement in margins in 2013 is encouraging, but they are in line with the expectations built into the September 2013 valuation, and entering the electric battery market is likely to lead to lower margins, not increase them. (The pre-tax operating margin for global electronics companies is 5.67% and that of power companies globally is 11.62%; neither is a perfect fit but you can download the industry average margins by clicking here). The decline in the cost of capital is more the consequence of change in the overall market environment, where the rise in overall stock prices in the last few months, has lowered the equity risk premium. Tesla’s foray into the bond market, with its $2 billion convertible bond issue, suggests that the company has opened up access to more capital, if it needs it, and shows up in the setting up of the probability of failure at 0%.

Overall, the effects of these changes is to increase the value of equity by about 105%. The effect on the value per share is smaller, largely because the company has 22.64 million options outstanding in addition to its 123.19 million shares outstanding. If we value these options, using the current stock price as the basis, we obtain a value per share of $100, but using the estimated value per share (I know.. I know.. there is circularity and that is why the excel spreadsheet is set to iterate) yields a value per share of $ 118. The danger with using the latter approach is that the option holders, assuming that they see what we see in this valuation, will be inclined to exercise when the price is high. Splitting the difference, the value per share estimate that I would attach to Tesla is between $110 and $115 per share.

Can the intrinsic value per share of a company close to double within a nine- month period? Yes, and with young growth companies, you should expect your estimates of value to be volatile over time, as you learn more (good and bad) about the company and its business. Does it bother me that value is so volatile? No, because it is not how volatile the value is, but how volatile it is, relative to price, that drives investment decisions. This is after all a company whose stock price has quadrupled, halved and doubled again all in the period of two years.

Price and Value

Tesla is a perfect case study for the dilemma that I posed for “value” investors in my post on buzz words, where you reject a stock as over valued, only to see the stock price increase even further. In September 2013, I valued Tesla at $67, when the stock price was $170, and concluded that it was over valued. Nine months later, the stock has gone up to $220, and even with my more optimistic outlook on the company, I have a value of $115-120, well below the market price. The trader ranks beckon, but as an investor, I have three choices with Tesla:

1. Delusion: Do a quasi DCF!

There is widely held presumption that if you have a set of cash flows on a spreadsheet, and you estimate a discount rate, you have done a DCF, which is the equivalent of claiming that wearing tights and ballet shoes makes you a ballerina. There are simple tests you can run to differentiate between good, bad and indifferent DCFs (and I will have a post dedicated to that topic), but in the context of Tesla, there are tweaks I can make to the model that can very quickly alter my value. For instance, if I set the sales to capital ratio at 10.0 (i.e,, that I can generate $10 of revenues for every dollar invested), the value per share goes to $302/share. Magical, right? The only problem is that I would then be assuming that Tesla will generate about $68 billion in incremental revenues and $9 billion in incremental profits, over the next decade, without building any factories or making acquisitions. Unless Tesla has discovered a way to build cars and batteries on virtual assembly lines, manned by Oompa Loompas, I don't see a way to justify this. In fact, Tesla's announcement that it would be investing $5 billion in its new electric battery factory suggests that the company knows that it has to make substantial infrastructure investments over the next decade, to deliver its growth potential.

2. Disruption and China: Attaching value to buzzwords
The last earnings report from Tesla was followed by the announcements that the company would start selling its cars in China and that it would be building a gigafactory to produce electric batteries. If you were working on a checklist for buzzwords, you would have hit the trifecta with this announcement: a company with growth potential announcing that it would enter China and disrupt an existing business. These announcements have valuation implications, but they have to be made explicit, if they are to the taken seriously.

Take, for instance, the argument that the electric battery investment represents the entrée into the market for supplying electric power for other uses (homes, businesses etc.). If the argument holds, it could be a value-changer, since the electric utility market is an immense one, in terms of revenues, albeit with much lower returns on capital. For disruption to justify today's stock price, the change in revenues will have to be far larger than the estimates in my valuation. If you believe that Tesla has the capacity to disrupt the electric utility business, the table below should give you a sense of the break-even points (to justify a $220 stock price):

There are a couple of interesting details in this table. The first is that while there is tremendous upside potential, the break even points to get to a $220 value are daunting. If the pre-tax operating margin converges on 12% (as assumed in my base case), you would need total revenues of more than $150 billion to justify the current market price. In other words, your battery business will have to add about $90 billion to Tesla's annual revenues by the tenth year. If margins drop, the current market value is not only unreachable, but growth can become a value destroyer. For instance, with a 4% operating margin, given the reinvestment needs in these businesses, increasing growth makes your value become more negative. If you buy into the disruption model, the challenge then becomes determining how much that disruption will create in additional revenues (in the electric utility business) without damaging profit margins. It is worth noting that Tesla is not the only player in this disruption game, with Honda having already jumped into the fray (albeit with their smaller and less powerful electric batteries) and Hyundai and Toyota getting ready to enter.

There is also the possibility that there are companies that would be interested in either acquiring Tesla (a tough task, since Elon Musk has been insistent that he will not sell) or partnering with it to create value on joint products. Given Tesla's burgeoning market capitalization, the list of potential acquirers/ JV partners does get smaller, but it is possible that the promise of a Google/Tesla driverless car could tempt Google to invest some of its substantial cash balance in Tesla.

3. Keep the faith

My investment philosophy is built on the foundation that you should buy an asset only if trades at a price less than your estimated value for that asset, error-prone and uncertain though the latter may be. It is true that I can offer no proof that my value is right, that the price is wrong or even if the first two assertions are true (right value, wrong price), that the price will adjust to the value, but is that not the essence of faith? That you believe, without proof! If I stay true to my philosophy, I cannot justify buying Tesla at the current price. Of course, a year from now, the stock may be at $400, but I will have no regrets, because I also believe that if you don't stand for something, you will fall for anything.

Your philosophy on investing may be different from mine, and probably better (or at least more lucrative). If you are a Tesla stockholder, though, I hope that you are one for the right reasons. That would include being a trader (whose focus is price, not value), buying into the disruption model or investing on the expectation of an acquisition, but it would not include investing because others have been making money on the stock, equity research analysts are bullish or just because you love the company, its products or its CEO.

Thoughts on markets

It is easy to become cynical about markets and to cast those who have different views than you do into the "irrational" or "crazy" camp. Even if the Tesla run-up turns out to be overdone, look at the bigger picture, which is that a company that was non-existent five years ago has shaken up a sector where there have been no new entrants for decades. I have nothing but admiration for what Elon Musk has built over these few years and I hope he succeeds. In fact, I will keep valuing Tesla, every few months, and there will be a time, sooner rather than later, where I know it will be part of my portfolio. Just not yet!

Note: If you don't like my assumptions or inputs, use the valuation spreadsheet below, change my assumptions to yours and make it your valuation. If you are so inclined, share your views in the Google shared spreadsheet that I created for this valuation.